7- 1  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Cost Information for Pricing and Product Planning Chapter 7

7- 2  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Introduction u Wendy Stone, the owner of High Performance Springs, was meeting with her marketing manager and her controller. u They were evaluating an offer from Lawson Corporation to purchase a large quantity of springs at $2.48 per pound.

7- 3  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Introduction u The accounting records show that the full cost of the spring is $2.79 per pound. u This cost includes $1.38 of direct materials, $0.76 of direct labor, and $0.65 of manufacturing support costs. u Should High Performance Springs accept this offer? u After reading this chapter, you will be able to...

7- 4  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Learning Objectives 1 Discuss the way a firm chooses its product mix in the short term in response to prices set in the market for its products. 2 Explain the way a firm adjusts its prices in the short term depending on whether capacity is limited.

7- 5  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Learning Objectives 3 Discuss the way a firm determines a long- term benchmark price to guide its pricing strategy. 4 Explain the way a firm evaluates the long- term profitability of its products and market segments.

7- 6  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Learning Objective 1 Discuss the way a firm chooses its product mix in the short term in response to prices set in the market for its products.

7- 7  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Role of Product Costs in Pricing and Product-Mix Decisions u An understanding of product costs enables managers to make informed decisions related to: – prices – discounts – utilization of capacity – product mix – deployment of marketing resources

7- 8  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Short- and Long-Term Pricing Considerations u Managers must consider both the short-term and long-term consequences of their decisions. u In the short run, resources committed to activities are likely to be fixed costs. u For short-term decisions, it is also important to consider the availability of capacity.

7- 9  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Short- and Long-Term Pricing Considerations u In the long term, managers have more flexibility to adjust capacity resources to meet demand. u Decisions about whether to introduce new products or eliminate existing products have long-term consequences.

7- 10  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Short- and Long-Term Pricing Considerations u What is a price taker? u It is a firm that has little or no influence on the industry supply and demand forces. u It chooses its product mix given the prices set in the marketplace for its products.

7- 11  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Short- and Long-Term Pricing Considerations u What is a price setter? u It is a firm that sets or bids the prices of its products. u It enjoys a significant market share in its industry segment.

7- 12  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Classification of Pricing and Product-Mix Decisions Decision Type Price-Taker Firm Price-Setter Firm Short-term decisions Long-term decisions 12 43

7- 13  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Short-Term Product-Mix Decisions – Price Takers Decision Type Price-Taker Firm Short-term decisions 1

7- 14  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Short-Term Product-Mix Decisions – Price Takers u A firm with a very small market share has little influence over industry supply, demand, and prices. u If the firm charges higher prices, customers go elsewhere. u If it charges lower prices, large firms could engage in a price war.

7- 15  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Short-Term Product-Mix Decisions – Price Takers u A price taker should produce and sell as many products as possible as long as costs are less than prices. u What are two important considerations? 1 Managers must decide which costs are relevant. 2 Managers may not have much flexibility to alter the capacities of some of the firm’s resources.

7- 16  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Short-Term Product-Mix Decisions – Price Takers u Consider Texmax, a small company in Mexico. u It sells ready-made garments to discount stores in the United States. Garment type Budgeted production Shirts12,000 Dresses 5,000 Skirts10,000 Blouses15,000 Total42,000

7- 17  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Short-Term Product-Mix Decisions – Price Takers u Production is limited by 19,800 machine hours. Garment Total Hours Type Hours Production Required Shirts0.412,000 4,800 Dresses0.8 5,000 4,000 Skirts0.510,000 5,000 Blouses0.415,000 6,000 Totals42,00019,800

7- 18  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Short-Term Product-Mix Decisions – Price Takers u Assume the following selling prices and variable costs: u Shirts selling price per unit is $5.00 and variable costs are $4.00. u What is the contribution margin per unit? u $1.00

7- 19  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Short-Term Product-Mix Decisions – Price Takers u Dresses selling price per unit is $15.20 and variable costs are $ u What is the contribution margin per unit? u $4.80 u Skirts selling price per unit is $9.00 and variable costs are $6.80. u What is the contribution margin per unit? u $2.20

7- 20  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Short-Term Product-Mix Decisions – Price Takers u Blouses selling price per unit is $8.00 and variable costs are $4.40. u What is the contribution margin per unit? u $3.60 u Assume that, in addition to the originally budgeted amount, another 2,000 blouses could be produced and sold at the existing price.

7- 21  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Short-Term Product-Mix Decisions – Price Takers u Should Texmax produce and sell these additional blouses? u Yes, because blouses have the highest contribution margin per machine hour. – Shirts:$1.00 ÷ 0.4 = $2.50 – Dresses:$4.80 ÷ 0.8 = $6.00 – Skirts:$2.20 ÷ 0.5 = $4.40 – Blouses:$3.60 ÷ 0.4 = $9.00

7- 22  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Short-Term Product-Mix Decisions – Price Takers u The contribution margin per unit of the constrained resource is the criterion used to decide which products are most profitable to produce and sell at the prevailing prices.

7- 23  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Short-Term Product-Mix Decisions – Price Takers u How should the 19,800 machine hours be used? – Blouses:17,000 ×.04 = 6,800 – Dresses: 5,000 × 0.8 = 4,000 – Skirts:10,000 × 0.5 = 5,000 – Shirts:10,000 × 0.4 = 4,000 u Notice that only 10,000 shirts can be produced.

7- 24  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Short-Term Product-Mix Decisions – Price Takers u What is an opportunity cost? u It is the amount of lost profit when the opportunity afforded by one alternative is sacrificed to pursue another alternative. u In order to produce the additional 2,000 blouses, Texmax must decrease the production of shirts by 2,000.

7- 25  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Short-Term Product-Mix Decisions – Price Takers u Each shirt contributes $1.00, so cutting back the production of 2,000 shirts causes a sacrifice of $2,000 in profits. Costs of Producing 2,000 Blouses Cost Type Per Unit Total Variable cost$4.40$ 8,800 Opportunity cost ,000 Total$5.40$10,800

7- 26  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Short-Term Product-Mix Decisions – Price Setters Decision Type Price-Setter Firm Short-term decisions 2

7- 27  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Short-Term Product-Mix Decisions – Price Setters u Setting the price of a product means determining its full cost and a markup percentage above cost. u This approach is known as cost-plus pricing. u Full costs include the sum of all direct materials, direct labor, and support activity costs.

7- 28  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Learning Objective 2 Explain the way a firm adjusts its prices in the short term depending on whether capacity is limited.

7- 29  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Capacity Issues u Special orders that do not involve a long-term contract should be priced in relationship to available capacity. u When capacity is available, incremental revenues have to be greater than incremental costs.

7- 30  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Capacity Issues u When capacity is not available, the minimum acceptable price must cover all incremental costs. u This will result in additional costs. u How can additional capacity be acquired? – overtime operations – subcontracting

7- 31  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Capacity Issues u What are incremental costs and revenues? u They are the amount by which costs or revenues change if one particular decision is made instead of another. u What is an incremental cost per unit? u It is the amount by which total production costs increase when one additional unit of a product is produced.

7- 32  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Capacity Issues u What are relevant costs or revenues? u They are the costs or revenues that differ across alternatives and therefore must be considered in deciding which alternative is the best.

7- 33  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Learning Objective 3 Discuss the way a firm determines a long-term benchmark price to guide its pricing strategy.

7- 34  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Long-Term Pricing Decisions – Price Setters Decision Type Price-Setter Firm Long-term decisions 3

7- 35  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Long-Term Pricing Decisions – Price Setters u Costs which are relevant for short-term pricing decisions are not the same as those which are relevant for long-term pricing decisions. u Most firms rely on full-cost information reports when setting prices.

7- 36  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Long-Term Pricing Decisions – Price Setters u There is economic justification for reliance on full costs for pricing decisions in three types of circumstances. 1 When contracts specify full cost of jobs plus markup 2 When a firm enters into a long-term contractual relationship with a customer to supply a product

7- 37  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Long-Term Pricing Decisions – Price Setters 3 When a firm adjusts its prices up and down to respond to changes in supply and demand, and the price tends to approximate the price on full costs u Most firms use full cost-based prices as target prices.

7- 38  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Benchmark Price High Demand Low Demand Month Short-Term Prices Relative to Long-Term Benchmark Price Price

7- 39  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Short-Term Prices Relative to Long-Term Benchmark Price u Prices depend on demand conditions. u Markups increase with the strength of demand. u Markups depend on the elasticity of demand. u Markups also fluctuate with the intensity of competition.

7- 40  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Short-Term Prices Relative to Long-Term Benchmark Price u What is elasticity of demand? u Demand is said to be elastic if customers are very sensitive to the price. u A small increase in price results in a large decrease in demand.

7- 41  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Short-Term Prices Relative to Long-Term Benchmark Price u When demand is relatively inelastic, profits will usually increase when prices increase. u Firms often lower markups for strategic reasons. u What are these reasons? – Penetration pricing strategy – Skimming pricing strategy

7- 42  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Pricing Strategies u What is a penetration pricing strategy? u It is charging a lower price initially to win over market share from an established product of a competing firm. u What is a skimming pricing strategy? u It is charging a higher price initially from customers willing to pay more for the privilege of possessing a new product.

7- 43  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Long-Term Pricing Decisions – Price Takers Decision Type Price-Taker Firm Long-term decisions 4

7- 44  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Long-Term Pricing Decisions – Price Takers u Decisions to add a new product or to drop an existing product from the portfolio of products usually have significant long-term implications for the cost structure of a firm. u Product-sustaining and batch-related costs are likely to change.

7- 45  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Learning Objective 4 Explain the way a firm evaluates the long-term profitability of its products and market segments.

7- 46  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Long-Term Profitability u When making long-term product mix decisions, managers use the full costs of products that incorporate the cost of using various activity resources. u Comparing product costs with their market prices reveals which products are not profitable in the long term.

7- 47  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Long-Term Profitability u If some products have full costs that exceed the market price, the firm must consider several options. – The impact of dropping products on the cost structure of the firm – The need to maintain a full product line

7- 48  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Long-Term Profitability – The redeployment or elimination of resources no longer used – The feasibility of changing resources committed to batch-related and product sustaining activities u Managers also may want to explore market conditions more carefully and differentiate their products further to raise prices and bring them in line with the costs.

7- 49  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Long-Term Profitability u When will dropping products help improve profitability? – When managers eliminate the activity resources no longer required to support the discontinued product – When managers redeploy the resources from the eliminated products to produce more of the profitable products that the firm continues to offer

7- 50  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Long-Term Profitability u Capacity constraints are likely to be less of a concern for product-mix decisions that have long-term effects. u Firms can adjust the level of resources committed to most activities. u Comparison of the price of a product with its activity-based costs provides a valuable evaluation of its long-run profitability.

7- 51  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Conclusion u Should High Performance Springs slash the price of its spring to obtain business from a reputable customer, the Lawson Corporation? u Fixed costs can be ignored, and variable costs alone are relevant only for analyzing a short- term pricing decision.

7- 52  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Conclusion u For long-term pricing decisions, the costs of many more resources are relevant because firms can adjust the supply of most resources over the long-term.

7- 53  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Conclusion u A case for a lower price for Lawson could be made as a part of a penetration pricing strategy. u High Performance Springs must consider the reaction of its existing customers. u It also must consider its competitors, who may cut prices to respond to Precision’s discounting.

7- 54  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young End of Chapter 7